SUN Tzu, the Chinese philosopher loved by Wall Street financiers, wrote in The Art of War that “the enlightened ruler is heedful, and the good general full of caution”. The Federal Reserve’s generals clearly subscribe to that mantra.

The US central bank drastically scaled back its interest rate projections on Wednesday, caving in to investors’ much more dovish view of where the benchmark federal funds rate was heading.

After ending its zero interest rate policy in December, the Fed had indicated that there would probably be four more quarter-point interest rate increases this year. Investors were more doubtful, however, and the carnage on global financial markets in January and February, coupled with concerns over the global economy, compelled the Fed to agree. Still, the extent of its caution has wrongfooted markets.

“I was shocked by the degree of dovishness, even though I was positioned on the dovish side of expectations,” said Steven Englander, a senior Citi strategist, in a note.

The Fed foresees just two increases in its interest rate corridor in 2016. And the fed funds rate, which it aims to keep near the midpoint in its band, will probably rise to 1.9pc in 2017, compared with December forecasts of 2.4.

Markets reacted with delight, reversing an early-day loss for the US stock market and lifting the S&P 500 index 0.5pc on Wednesday, although banks closed lower.

The bond market also enjoyed a hearty rally, which continued early yesterday. That crimped the 10-year US Treasury yield to 1.87pc, after it had flirted with the 2pc level earlier in the week. Reflecting the fact that US monetary policy will now probably diverge less dramatically from its counterparts, the dollar also fell sharply.

Central bank faces charges of being swayed by sentiment as it halves rate rise projections

But the shift in the Fed’s stance emboldened more dovish investors, and paradoxically caused markets once again to pare back expectations for interest rate increases, putting the central bank in an awkward spot.

The recovery in financial markets this month had boosted rate expectations before Wednesday’s meeting, with fed funds futures indicating there was almost an even chance of two rate increases this year. Yet the sense that the Fed had undergone a pivotal shift led rate expectations to fall further rather than firm up after the meeting.

As the dust settles, fed funds futures indicate that investors see a greater chance of the Fed holding fire for 2016 than raising by the revised two times.

Reflecting the market view that officials have become more sanguine on inflation, so-called ‘break-evens’ - the implied future inflation rate derived from comparing the yields of conventional and inflation-protected Treasuries - rose sharply. The five-year break-even climbed towards 1.5pc for the first time since July.

“The break-even reaction tells you all you need to know,” says Joachim Fels, global economic adviser at Pimco. “The Fed is telling us that they’re willing to allow an overshoot in inflation.”

However, some analysts say the dovish shift signalled that policymakers were influenced more by movements in fickle financial markets than by the underlying economic data. This old accusation will gain weight, warns Gregory Peters, senior investment officer at Prudential Fixed Income.

“It shows that they are a lot more market-driven than data-driven,” he says. “It’s a threading-the-needle-type situation. It makes the communications more challenging, and there are times when you need to disconnect from financial markets and do what you think is right for the economy.”

Of course heeding the warnings of markets may be prudent - especially given the severity of this year’s turmoil. “Financial markets are a very important transmission mechanism, so they cannot ignore them,” says Mr Fels.

Moreover being guided by volatile markets introduces further uncertainty into monetary policy.

Much of the early-year choppiness has receded, so as the Fed sticks to the sidelines, market sentiment is likely to continue improving. That raises the prospect of the Fed shifting back into a more hawkish gear.

Published in Dawn, Business & Finance weekly, March 21st, 2016